Moves in the dollar are critical to global markets and may eventually have a negative impact on U.S. stocks.

Every year has its share of surprises for investors, and one of 2018’s has been the outperformance of U.S. stocks relative to the rest of the world. The S&P 500, a benchmark of the U.S. market, is up 8% year to date, while an index of global equities that doesn’t include the U.S. is down 5%.

There are many reasons for the divergence. Domestic politics in places like the United Kingdom, Brazil and Italy hurt returns in those countries. The U.S. dollar strengthened, measured against a basket of major currencies, and trade tensions hit China and emerging markets. In contrast, U.S. markets were boosted by tax cuts, fiscal stimulus and investor perception that they could be a “safe haven” from market volatility in the rest of the world.

Even the 40% decline in the value of Turkey’s currency against the dollar this year, which has raised concerns about a replay of the 1997-1998 emerging-market debt crisis that started with the Thai baht, hasn’t been enough to shake U.S. investors from apparent complacency.

In truth, while Turkey’s currency decline is detrimental to its economy, it seems to be a contained problem. I don’t expect it to spread to other currencies. However, it does show how important a stable relationship to the U.S. dollar is to the health of many foreign markets.

Below are three reasons why a strong dollar can be challenging for countries, like Turkey, that have issued a lot of dollar-denominated debt to fund growth, and how that can potentially impact U.S. equities:

Countries that have borrowed in dollars see their total cost of debt service go up as the dollar strengthens against their own currencies. Liquidity can dry up and credit growth can slow, ultimately leading to slower economic growth.

Commodities are usually priced in dollars so foreign buyers effectively have to pay more when the dollar strengthens. That can result in less demand, leading to lower prices. The sale of commodities is a key revenue source for many emerging market countries.

The stronger dollar makes U.S. exports relatively more expensive and less competitive overseas. Plus, weakened economies in the rest of the world may not buy as much from U.S. multinationals, potentially hurting U.S. equities.

What if the dollar weakens? That could be quite negative as well. Commodity prices might rebound, triggering higher inflation readings that reinforce the Federal Reserve’s intent to keep raising interest rates. Sharply higher interest rates could hurt the U.S. government bond market and upend stocks as well.

Bottom Line: I think we are at a critical juncture where positive U.S. market returns may be dependent on the dollar staying range-bound. Big moves in the dollar—up or down—could cause markets to downshift. Pay attention to the U.S. Dollar Index—you can check the symbol (DXY) for evidence of a sharp move in the value of the dollar against a basket of currencies. If you own a lot of index funds or exchange-traded funds, consider reducing your exposure to such passive investments in favor of active fund managers, who may be able to help manage currency shifts and navigate current global markets.

Risk Considerations

Investing in foreign and emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

An investment in an exchange-traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on an exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock and bond prices. Investing in an international ETF also involves certain risks and considerations not typically associated with investing in an ETF that invests in the securities of U.S. issues, such as political, currency, economic and market risks. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics. ETFs investing in physical commodities and commodity or currency futures have special tax considerations. Physical commodities may be treated as collectibles subject to a maximum 28% long-term capital gains rates, while futures are marked-to-market and may be subject to a blended 60% long- and 40% short-term capital gains tax rate. Rolling futures positions may create taxable events. For specifics and a greater explanation of possible risks with ETFs¸ along with the ETF’s investment objectives, charges and expenses, please consult a copy of the ETF’s prospectus. Investing in sectors may be more volatile than diversifying across many industries. The investment return and principal value of ETF investments will fluctuate, so an investor’s ETF shares (Creation Units), if or when sold, may be worth more or less than the original cost. ETFs are redeemable only in Creation Unit size through an Authorized Participant and are not individually redeemable from an ETF.

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Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

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